Oil price blame game misses point

Blame the speculators. Blame the profiteering oil companies. Blame America's threats towards Iran. The hunt for a culprit for $75-a-barrel oil has begun and, as usual when the price is debated, the single biggest reason for the rise will probably be lost in rhetoric.

The truth is that the iron law of supply and demand operates in oil, just as it always has. Too little supply and too much demand may sound too simplistic by half, but worries such as Iran only gain purchase when the fundamentals are out of line. In this case, as Credit Suisse's analysts put it yesterday, the market's focus is on the fact that "there is practically zero spare oil production capacity available to cover large supply outages".

It is another way of saying that the seeds of the current crisis were sown in the 1990s. If you want a key event, it was Opec's meeting in Jakarta in 1997, when the cartel raised the output quotas of its members. The Asian currency crisis then struck, undermining demand from the region that was expected to be the greatest source of new demand.

Oil soon fell to $10 a barrel and, in 1999, the Economist magazine famously made a terrible call. Under the front-page headline "drowning in oil", it predicted that $5 a barrel was on the way. Plenty of sensible people actually believed that, or something like it. Some were running oil companies.

Here is Sir Mark Moody-Stuart, then chairman of Shell, in October 2000, when the oil price had recovered to $30. He stuck to Shell's long-term forecast of $14 and added: "In the longer term, technology will increase production capacity and tend to drive the oil price somewhere below $20 a barrel."

Prediction can make a fool of anyone. The point is that Shell, like most of the other oil majors, was making investment decisions on these assumptions. Sir Mark, in that same 2000 webcast, said he would look at increasing Shell's capital expenditure "in a disciplined way" from its annual level of $10bn; three years earlier, the group's investment had been $16bn.

Shell turned out to have problems all of its own (like the fact that its reserves were overstated by 20%), but constraints on investment were virtually industry wide. Post-tax profits for the six biggest American producers fell 90% in the last quarter of 1998, the year after that Opec meeting in Jakarta. The oil game was about cost-cutting, mergers and muddling through - just as it was in Opec countries. The likes of Saudi Arabia do not have shareholders to satisfy, but they do need to maintain a welfare system to keep frustrated citizens at bay.

The arrival of $10 oil had an effect that the Economist wholly overlooked. Demand boomed as Asia, led by China, recovered. Supply, of course, has not kept up because investment had been slashed. You can't just turn on the taps: it takes about 10 years to get a new oil discovery to production.

It is just about true, as the Saudi oil minister said yesterday, that Opec has been pumping as much oil as the refineries can handle. The worry is whether it could maintain that boast if, for example, Iran (5.2% of the world's production) went offline, or if shutdowns in Nigeria (3.2%) escalated. As the chart (below) from Credit Suisse shows, spare capacity, expressed as a percentage of demand, is at its lowest level since the Iran-Iraq war.

The good news is that $75 oil is unsustainable, just as $10 oil was. At some point, demand and supply will come back into balance. Indeed, the rate of growth in demand may now be only 1%. A problem is that Opec may have underproduced in the first quarter of this year, says Credit Suisse.

If that is so, even higher crude prices are quite possible. A year ago, Goldman Sachs made its well-publicised prediction that a "super spike" of $105 could happen - reasoning that oil prices needed to be high enough for long enough to reduce global energy consumption meaningfully. It is doubtful that even a slowdown to growth of 1% counts as meaningful.

More supply is on the way because there are enough oil prospects in the world, but it takes time. The industry is still scrambling to recover from the under-investment of the 1990s. Rigs, platforms, tankers and every other piece of infrastructure are still in short supply. But they are certain to arrive with $75 oil.

That is the point about oil - it is a commodity, and commodities have always fluctuated between boom and bust and periods of over-investment and under-investment. The bad news is that, as a rule of thumb, a typical commodity cycle lasts a decade and a half. This story could run.